Factors Affecting the Valuation of Corporate Bonds

Abstract

The valuation of corporate debt is an important issue in asset pricing. While there has been an enormous amount of theoretical modeling of corporate bond prices, there has been relatively little empirical testing of these models 1 . Recently there has been extensive development of rating based reduced form models. These models take as a premise that bonds when grouped by ratings are homogeneous with respect to risk. For each risk group the models require estimates of several characteristics such as the spot yield curve, the default probabilities and the recovery rate. These estimates are then used to compute the theoretical price for each bond in the group. The purpose of this article is to examine the pricing of corporate bonds when bonds are grouped by ratings, and to investigate the ability of characteristics, in addition to bond ratings, to improve the performance of rating based models. Most of our testing will be conducted in models which are in the spirit of the theory developed by Duffie and Singleton (1997) and Duffie (1999) The paper is divided into three sections. In the first section, we discuss various reduced form models that have been suggested in the literature. In the second section we examine how well standard classifications serve as a metric for forming homogeneous groups. In this section we show that using standard classifications results in errors being systematically related to specific bond characteristics. Finally, in the last section we take account of these specific bond characteristics in our estimation procedure for determining spot prices and show how this lead to improved estimates of corporate bond prices.